DATELINE: May 27, 2008, Chicago
Those interested in ascertaining the direction in which the Internal Revenue Service is moving used to wait for revenue rulings, but in recent years, the IRS has moved away from issuing revenue rulings. It still does, but far less frequently. The tea leaves have taken a variety of forms. In the exempt organization area, determination letters denying tax-exempt status appears to be where the action is these days. Case in point, IRS Determination Letter 200821037 (released May 23, 2008).
We probably agree with the IRS's decision...
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to deny this entity tax-exempt status, but we don't like how it reached that result. We suspect many EO lawyers and accountants will agree with us. Rather than focusing on the logical reason for denying tax-exempt status, the IRS throws out a variety of reasons.
One advantage with revenue rulings was that they were "on the record," and therefore, carefully crafted. This determination is "off-the-record" and not carefully drafted. In the law business, when deciding a case, the rule is that you say no more than is necessary to get to the result. The IRS has violated that rule and needs to give more careful consideration to the reasons it gives for denying tax-exemption.
The Facts: M is described as the entity requesting recognition of status as a Section 501(c)(3) organization. M's exempt purpose was education. To achieve that purpose, M planned to produce programs across the United states, which would include music festivals, invitational concerts and workshops, prepared recording competitions, honor concerts, all-star touring ensembles, and other events identified by active teachers as viable events. Participants in the events will include band, choir and orchestra ensembles and individuals from all age groups. The events will be developed by committees comprised of active educators, requests from civic and development leaders in communities from abroad, events recommended by other nonprofit music education organizations, and events licensed from existing companies in the music industry. Although the facts are not clearly stated, M appears to be focused on band, choir, and educational students across the United States. M seeks to develop and provide opportunities for music students, to recognize and celebrate musical achievement, and to become the voice of music educators. M also will make grants to educational institutions for scholarship funding. The organization looks quite similar to the one in Revenue Ruling 67-392, 1967-2 CB 191, a ruling cited in the determination letter. That ruling concluded that the organization in question was a charitable organization. For a discussion of performing arts organizations that appear to have similar purposes and conduct activities similar to M, see Bruce R. Hopkins,The Law of Tax-Exempt Organizations (Law of Tax Exempt Organizations)
At this point, M sure sounds charitable to us, but the determination reaches the contrary result, due to a number of additional facts. These include:
- Spin-Off. M is a spin off of P, a for-profit travel and tour operator.
- Working Relationships. M and P will maintain a working relationship, with referrals between the two organizations. For example, M's Web site refers potential customers to P for assistance with transportation, lodging, and meals. P appears to be focused on group travel and presumably would be assisting bands, choirs, and others in attending events sponsored by M.
- Contracted Services. M has contracted with P for a wide variety of services, which include (i) hiring, managing, and firing M's employees; (ii) managing M's performance venues; (iii) investigating new products for M; (iv) maintaining databases; (v) providing vehicles and transportation needs for M's office staff and contract laborers; (vi) managing communication with all of M's "customers;" and (vii) undertaking other enumerated activities. M will reimburse P for these services on a monthly basis. It appears the reimbursements will be for P's costs, referred to as "reasonable expenses." The facts then state that the reimbursements are not to exceed fair market value, suggesting that there may be an element of profit.
- Lease of Space. M will lease space from a company owned wholly or in part from A, a board member of both M and P. M submitted an appraisal indicating that M was paying no more than fair market value to lease the faciliy.
- Board Overlap. M has a 9-member board that is self-perpetuating. Only board member A serves on the boards of both M and P.
- Attorney Overlap. P's attorney serves as an officer of M.
- Budget and Finances. The IRS provided extensive budgetary information, but all amounts were redacted. Most notable is the "Cost of Goods Sold" category listed under income. This could mean that revenues received from others were billed at cost, but this is a highly unusual and confusing reference. Cost of goods sold are an expense. In the future, the IRS should consider providing relative percentages if it believes it must redact the amounts and clarifying unclear terminology.
Telegraphing the Punch. The IRS sets out the facts so that the outcome is obvious long before the IRS gets to the analysis, let alone the conclusion. To us, the spin-off, combined with the service contract, were clear indicators that the IRS would rule that the organization was not tax-exempt.
Let Us Count the Ways. The Service denies M Section 501(c)(3) status because:
- M serves private interests.
- M's earnings inure to P
- M's primary activity of organizing musical events throughout the world on a fee basis is an unrelated trade of business.
- M is funded almost entirely by fees and lacks the donative element necessary to characterize its activities as charitable.
What's Wrong With This Picture. There are several things wrong with this picture. First, the IRS could have easily disposed of the matter by focusing on private benefit. Although we don't have all the facts or the full context, this looks like a "tail-wagging-the-dog" case. M appears to have existed to stage events so that P could profit from providing travel arrangements to those who participated in M's activities. The IRS cites est of Hawaii v. Commissioner, 71 T.C. 1067 (1979) for the proposition that there can be inappropriate private benefit even if all the financial transactions between the two organizations are a fair value. The IRS also referred to in Church by Mail v. Comm'r, 765 F.2d 1387 (9th Cir. 1985), in which the court said that the "critical inquiry is not whether particular contractual payments to related for-profit corporations are reasonable or excessive, but instead whether the entire enterprise is carried on in such a manner that the for-profit organization benefits substantially from the operation" of the tax-exempt entity. Add in the fact that M never sought bids on what was a management contract with P and you have a pretty good case of private benefit. But for P, M would not exist, or at least that should have been the argument.
But the IRS went far beyond private benefit. It brought up the donative-element test. Hopkins discusses this test in Section 6.9 of his book under the heading "Consortia." "Consortia" refers to cooperative joint ventures, where one entity is formed to provide services to another. The putative tax-exempt entity often is denied tax-exemption. If, however, the organization can demonstrate that at least 85% of the organization's sources of revenue come from outside the consortia, the entity may be treated as exempt. See Revenue Ruling 71-529, 1971-2 C.B. 234. There the entity provided investment services at below cost to colleges and universities, receiving a signficant portion of its revenue from grants made by other charitable organizations.
The IRS does not do a good job of enunciating the donative-element test. The determination letter states:
M is funded almost entirely through fees for services and thus lacks the donative element necessary to characterize its activities as charitable.
This language seems to go well-beyond the type of consortia that Hopkins is referring to. Can it be read to suggest that social service agencies that rely heavily on government grants are not tax-exempt because they provide their services at cost and receive no charitable contributions? What about nonprofit hospitals? We have heard that many of these institutions rely much more heavily on fees and government payments than charitable contributions. Is the donative-element test confined to consortia, or is the IRS expanding the test in this determination letter to focus on whether the activity is subsidized by charitable contributions?
In the case, we are told that M's fees for services constitute 85% to 90% of its revenues. We assume these are fees paid other than by P--the facts are not clear, but we assume M will receive revenues from performance ticket sales. Those aren't charitable contributions, but they are outside of the M-P relationship.
The confusion over or possible extension of the donative-element test may not be a coincidence. The donative-element test is discussed in Section 6.9 of Hopkins, but the index refers to Section 6.8, which refers to arts organizations and cites a case in which the judge refers to the subsidy from contributions. Did someone read Section 6.8 first, then Section 6.9, and then conclude that the donative-element test should be expanded to situations described in Section 6.8?
As noted, the IRS also concludes the M is engaged in an unrelated trade or business. We disagree with the IRS's reliance on Section 513 of the Code. It is needless overkill that is confusing and misdirected. If M is not a charitable organization because it is a Section 501(c)(3), then there is no need to address Section 513. Second, in determining whether an activity is unrelated, the focus is on the relationship of that activity to the performance of the organization's exempt function. Although the exact facts are not entirely clear, it seems likely that the activity is in furtherance of and related to M's putative exempt function and purpose. The IRS should not be conflating private benefit with unrelated. Other organizations might engage in the same activities, but do so independent of their founding organization. Those organizations could very well receive charitable contributions, require competitive bidding for goods and services that they use, and deal with insiders at arms' length. In such case, we find it unlikely that Section 513 would come up.
What the IRS Is Going to Do with the Redesigned Form 990. It is difficult to read this determination letter and not smile as you think about the redesigned Form 990. Many of the questions on the redesigned form identify the sort of facts that posed a problem for M. There are undoubtedly organizations out there that started out as newly minted entities that then drifted into the sorts of dealings that M engaged in from the outset. Once the IRS has its audit screens computerized, we suspect there will be a number of cases revoking the exempt status of organizations that have gone astray.
The Importance of Denial/Revocation Letters. After the release of Determination
Letter 20080818023 (May 2, 2008) two weeks ago, it is becoming apparent that denial/revocation letters are where the action is these days. Advisors to taxpayers would be well-advised to start reading these letters on a regular basis. They provide a window into the soul of the IRS.
What was M Trying to Accomplish? We also have difficulty understanding what M and P were up to. P is a taxable entity. When all the activities were in one entity, P offset any income it earned against the expenses. Spinning off M doesn't seem to accomplish much. The ruling suggests that M isn't relying on charitable contributions, which would mean it doesn't need Section 501(c)(3) status in order to attract such contributions. Exempt status seems to have little value if it is billing for its services at cost and paying for services provided by P at cost. Possibly it wanted the status because if had some value for purposes of obtaining a property tax exemption under state or local law. But M leases its property from a for-profit entity so we find it hard to see how the property qualifies for exemption. In short, the ruling doesn't provide a very clear understanding of what is motivating the parties.
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